Court Denies Motion to Dismiss in First Opinion Issued in Chinese Reverse Merger Securities Fraud Cases

August 4, 2011


In a ruling that could signal the willingness of courts to hear reverse merger securities fraud actions (also known as reverse takeover or RTO), a federal judge last month rejected a Chinese company’s motion to dismiss. The July 20, 2011 ruling by Judge Valerie Baker Fairbank of the U.S. District Court for the Central District of California was the first reported opinion of its kind involving a complaint against a Chinese company that listed its shares on a U.S. exchange through a reverse merger. In Henning v. Orient Paper, Inc., CV 10-5887-VBF (AJWx), 2011 U.S. Dist. LEXIS 79135, at *1-*2, *22 (C.D. Cal. July 20, 2011), the court held that plaintiffs had sufficiently pleaded securities fraud under the Private Securities Litigation Reform Act (“PSLRA”) and denied defendants’ motion to dismiss despite plaintiffs basing nearly all their allegations on an Internet report authored by an admitted short seller.

Orient Paper, a Hebei Province-based producer and distributor of paper products, was among the first Chinese reverse-merger companies to fall victim to a short-seller attack—a phenomenon that has targeted more than two dozen Chinese companies this year alone. As with most such attacks, Orient Paper was the subject of an online “exposé,” this one prepared by Muddy Waters, which stood to profit if Orient Paper’s stock declined. Predictably, after Muddy Waters released its report in June 2010, purporting to reveal fraud in the company’s financial statements, Orient Paper’s stock dipped 13% overnight and plunged an additional 32% over the following six weeks. In what has become another fixture of short-seller attacks, the report was followed two months later by a securities fraud class action.

In Orient Paper, plaintiffs followed the blueprint laid by Muddy Waters, alleging that the company failed to disclose material related-party transactions with its main supplier and materially misstated its financials in its annual reports for 2008 and 2009 based on a comparison of Orient Paper’s SEC filings with its Chinese regulatory filings. Id. at *3. Plaintiffs also alleged that the company’s auditor was disbarred and therefore unlicensed, rendering the financial statements it audited unreliable. Id. Plaintiffs further alleged that the “truth” about Orient Paper’s accounting practices was revealed on June 28, 2010, when Muddy Waters, which admitted to holding a short position in the company’s stock, issued a report “bringing to light various alleged frauds,” and further revealed in subsequent reports thereafter. Orient Paper denied the report’s claims and conducted an internal investigation that “concluded favorably for ONP [Orient Paper].” Id. at *4.

Defendants moved to dismiss the complaint, arguing that plaintiffs failed to allege a material misstatement or omission with particularity and, thus, failed to satisfy the PSLRA’s heightened pleading requirements. The court, however, held that defendants’ arguments raised factual disputes that were inappropriate on a motion to dismiss. Id. at *10-*12. Although defendants also argued that plaintiffs failed to allege facts giving rise to a strong inference of scienter, the court held that “[v]iewed holistically . . . the inference of scienter advanced by the Plaintiffs is ‘at least as compelling as any opposing inference one could draw from the facts alleged.’” Id. at *22 (citation omitted). The court found that the alleged related-party transaction indirectly benefited the defendants and, therefore, created a strong inference of scienter. Defendants’ failure to sell company stock and Orient Paper’s independent investigation did not negate this inference. Id. at *13. The court also found the company’s internal investigation to be “questionable,” at least in part because the outside firms hired by the company’s audit committee did not submit attestations of the work performed. Id. at *4. Finally, the court held that plaintiffs had sufficiently pleaded loss causation. Defendants argued that Orient Paper’s statements were not false and that Muddy Waters’s “unsubstantiated rumors,” and not the revelation of any truth, caused the company’s stock to decline. The court, however, found that “the publication of the alleged frauds caused the loss from which Plaintiffs suffer.” Id. at *21-22.

More than 24 securities class actions have been filed against Chinese reverse merger companies in 2011, many of them preceded by disparaging reports from self-interested and often anonymous short sellers. Several cases are currently in the briefing stage of motions to dismiss. If this first motion to dismiss opinion is any view into the future, and defendants are unable to challenge the truth of the short seller reports at the pleading stage, most of these cases appear poised to proceed past the pleading stage and, instead, their issues will more likely be decided on motions for summary judgment. Defendants will likely be forced to expend significant time and resources participating in full-blown discovery, challenging class certification and engaging experts prior to resolution.